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As some commentators have astutely pointed out, having a mortgage or other debt is similar to being short bonds in your portfolio because they have similar structures and often you can earn more by paying off the debt than by owning bonds. A good asset allocation should take this into account, but I haven’t really looked at it this way yet. Currently our portfolio is 5% in bonds, using the DEX Universe index which yields around 2.5% with a term around 9 years and a duration around 6 years. Our mortgage is 4x the size of our portfolio, at an interest rate of 2.99% which is fixed for most of the next 5 years.

Clearly this is a a pretty good time to be short bonds. The interest rates are firmly in favor of borrowers, and punishing to lenders. And we are taking advantage of this by holding on to our debt and investing more in stocks. The two questions to ask are:

Is this the right balance?

Does it make sense to hold bonds while having a mortgage at a higher interest rate?

Even though I haven’t looked at the mortgage as a reverse bond, we have already considered something similar. We started off our mortgage with fairly good equity and increased the regular payments 25% in the first year to make it go faster with just over 16 years left today. While we would like to increase the payments further, with the current environment we are taking everything else we can get in our regular budget and investing it in the portfolio (which is 95% stocks). So we’ve allocated the overall balances and monthly cashflow in a way that makes sense based on those incremental decisions.

The main reason to keep a small holding of bonds (I would even say the only reason for us to look at them today), is so we can re-allocate them in case stock markets fall further. If there is a great buying opportunity we wouldn’t have much to invest besides our regular monthly cashflow, so the bond position could be deployed to a nice cheap market. The value is about the same as 1.5 months of automatic investments so the effect wouldn’t be huge. If the stock markets do rise quite a bit more and bond interest rates improve, we can always re-allocate some of the portfolio from stocks to bonds.

So it might make sense to move those holdings to stocks now or use it as a mortgage prepayment. If we don’t do one of those we are losing about 0.5% on the interest rate spread between the bonds and the mortgage, plus the risk that the prices of the bonds will fall when interest rates rise. Do those counter-balance the value of the option to buy stocks cheaply? It’s hard to say. The market doesn’t seem to be positioned for a big fall at the moment (and in the US we know someone who really doesn’t want that to happen). But volatility and investor behavior do crazy things so it could easily happen when we least expect it. And we aren’t set up to increase our mortgage balance without having to refinance (which I believe could be done up to the original balance with minimal costs). We don’t want it to go back up, so once we make a payment there we don’t plan to take it back which removes some options.

Including your debts as a negative balance could be a useful way to look at your portfolio, in combination with other off-balance-sheet items such as your future income and expenses. The decisions we’ve made are an approximation, but may not be the best if we look at them this way.

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I’ve seen a few references to Zvi Bodie’s writing over the years. His book apparently encourages investors to plan for their retirement using inflation-indexed bonds, and ignore stocks. In a recent WSJ article he responds to readers’ questions about this strategy.

Near the end a reader asks what size of portfolio would be needed to reach a certain annual income, and he replies: “With real rates so close to zero, you’ll get a good estimate by simply multiplying $85,000 (or the income you need) by the number of years you expect to need it.”. In other words, expect no investment returns and just plan to spend the cash you’ve stockpiled! And if you want to be prepared in case you live an extra 20 years, you’ll just need to have a career twice as long before retiring.

I still have enough confidence in financial markets to try doing better than that, although I will stay away from investments that aren’t likely to produce a good real return over time (much like inflation-linked bonds with real interest rates near 0%).

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About This Blog

This is where I write about investment/finance ideas and useful information I come across as I refine my personal investment plan. I also write a more general blog about creating and enjoying wealth at Simply Rich Life. Check it out!